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Does Size Matter?
By Mark W. Sheffert
December 2005

Did I get your attention with the headline? Okay, now get your mind out of the gutter and back to business.

To find the answer to that age-old question, perhaps we should turn to a wise old man, Yoda, the character from George Lucas’s Star Wars movies, who said, “Size matters not. Look at me. Judge me by my size, do you? Hmm? Hmm? And well you should not. For my ally is the Force, and a powerful ally it is.”

But I wonder what Yoda would say about size in business. It seems like common sense that increased size in sales volume must result in sizable profits, right? Even R2-D2 would agree with that one, I think. Well, I’ve found over the years that it isn’t always so, and too many business leaders lack wisdom about this aspect of running their companies.

Let me explain. Our firm recently worked with a contract manufacturer of components in the technology industry, a company with $1 billion in revenues. Now I’d say that was a nice-sized company, wouldn’t you? The only problem was that despite all those revenues, it was losing money and management couldn’t figure out why. We conducted rigorous analysis and started to figure out the cost structure. Analysis showed that the company was losing money on the top 10 percent to 15 percent of its customers, based on sales volume, due to “high-touch” service costs.

Senior managers explained this away by giving the “contribution to margin” arguement. In other words, they thought that it didn’t matter if they were losing money on these sales, because their sheer volume absorbed
infrastructure costs. That’s right—and if you believe that story, you probably still believe in the Tooth Fairy, too. You can’t contribute to margin if you’re going broke, for crying out loud! So we helped them figure out how to cut expenses, and they talked to their customers to work out pricing increases and/or changes to specifications to lessen the amount of specialized tooling required and so decrease the manufacturer’s cost of goods. Now this company is back on the road to profitability.

For a smaller client, a $70 million company that did contract manufacturing in metal, the findings of our analysis were similar. We found that it was losing about $2 million annually on sales to its top 10 customers, who accounted for 40 percent of total revenues. Again, executives were hanging their hats on sales volume, not realizing that there was more money going out the door to chase and service those sales than was coming in the door. When this company talked to its customers and explained the situation, the customers were remarkably willing to work things out.

The good thing about this experience was that our client found out how much its customers valued the products, and that customers wanted to work with the company to find mutually beneficial solutions that would keep it operating—profitably. Most customers agreed to higher pricing, and all of them worked with our client to find ways to reduce costs in producing their custom products.

Another recent client, a $50 million printing company that wasn’t profitable, was making a similar mistake. We discovered that about 50 percent of its total sales were jobs that brought in less than $3,000 each, but set-up costs were more than that. That’s why the company was in the red by about $2 million annually. Its solution was simply to reprice these smaller printing jobs to reflect the set-up and breakdown costs, and then let customers decide to either pay more or go somewhere else. It was very painful at first. In fact, revenues decreased 10 percent the first year. However, that same year, the company was nearing about $3 million in profit.

These examples serve to show that big top-line revenue growth doesn’t necessarily mean big profits. I, for one, would much rather have a small, yet very profitable company; being able to brag about volume is a shallow victory if you’re losing money while you’re playing the game.

It reminds me of a saying among golfers, “Drive for show, but putt for dough.” Driving is analogous to growing revenues: It looks pretty and feels good. But putting, which is analogous to growing profits, is more difficult and pays off when it’s done well.

The Supply Chain Executive Board, an organization in Washington, D.C., recently analyzed 750,000 order records from three large companies in the consumer products, chemicals, and electronics industries. Results, as reported in the September 2005 Harvard Business Review, showed that firms providing “uncontrolled supply-chain services sacrifice sub-stantial profits”—in fact, about 20 percent of profit—for just a 3 or 4 percent increase in revenues. The board also found that the customers these companies had ranked as their “best” customers placed 40 percent of the unprofitable orders.

So our clients are not alone; it seems that many companies use conventional accounting methods that don’t show the true costs of servicing their “best” customers. It’s an easy trap to fall into: A good customer needs something and we bend over backward to make them happy with customized specifications and tooling, specialized packaging and labeling, high-touch delivery service and warranty programs, et cetera. Most of these costs are lost from view in our efforts to push sales volume. I’m not saying that we shouldn’t give good customers special treatment, because that’s also what makes good customers loyal customers. I’m just saying that if that special treatment isn’t priced right, pretty soon there is more money going down the drain than into the bank.

Let’s say you have a customer, Customer A, who places orders via your Web site, orders standard products without any changes, rarely needs assistance from your customer service department, and has even set up automatic online payments. Meanwhile, Customer B never uses your Web site to place an order. He spends at least 30 minutes on the phone with one of your customer service people each time he needs something, because it’s rarely one of your standard products. And he pays his bills with paper checks, which are usually late. It would be prudent to find a way to reward Customer A for helping you to reduce your costs to serve him, and at the same time, motivate Customer B to do the same, don’t you think?

If you don’t have an internal control process that can help you figure out which of your customers you’re losing money with, check out one of many cost-to-serve software programs that identify profitable and unprofitable customers by measuring your total service costs. These programs can also help you to figure out how to implement relationship pricing to recoup your costs.

But the answer is more complicated than buying a software program. My point is that we all need to be cautious and informed about customer relationships, and have internal controls that help us avoid an ongoing drain on profits. Because, after all, as another wise old man, Mark Twain, said, “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.”

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